Reverse mortgages are a way for elderly people to draw an income (either in installments or a lump sum) against the equity that they've built up in their homes. For many older people in need of funds to live on, it is nothing short of a blessing, but there are some pitfalls to the process that everyone should consider. Find out what you need to know before taking the plunge. (For further reading on reverse mortgages, see The Reverse Mortgage: A Retirement Tool.)

High Costs

Although an individual is technically tapping the equity on his or her own house, the bank charges a fee to initiate the transaction. In fact, according to ReverseMortgage.Org, as part of a reverse mortgage, homeowners may be required to pay an origination fee of $2,000 or 2% of the loan amount, whichever is higher. Some homeowners choose to fold this fee into the loan and pay it back over time with interest.

In addition, there are other fees that homeowners may be responsible for, such as an appraisal fee, which can range in the hundreds of dollars, a recording and credit report fee, which tends to be about $200, and a pest inspection and a flood certification fee, which are about $150 (for both). Finally, homeowners may also be asked to get mortgage insurance, and may be charged a flat monthly account "service fee", which can range from $30 to $35 a month. In short, the costs associated with a reverse mortgage can initially nibble away at the income you'll receive.

Homeowners in need of liquidity who are considering selling their homes within the next several years would probably be better off applying for a more traditional line of credit, a home-equity loan or a personal loan, given the large upfront costs associated with the process. (To learn more about home equity loans, see Home-Equity Loans: The Costs and The Home-Equity Loan: What It Is And How It Works.)

Your Kids Might Not Inherit the Family Home

Parents may like to pass the family home onto the next generation. However, when a reverse mortgage is taken out, even though the lending institution does not take title to the home, the mortgagee has an obligation to pay back the loan over time with interest. In many cases, that repayment is made by selling the home and then turning over the proceeds (or a portion of them) to the bank.

As a possible workaround to avoid selling the family home, some families will take out an insurance policy on the homeowner and then make an adult child or the lending institution the beneficiary. Using this strategy, the bank may be repaid without having to sell the property upon the homeowner's death. Consider consulting with an insurance agent to determine the best way to ensure that proceeds from such a policy are sufficient enough to satisfy the outstanding loan.

Impact on Future Financing

When an individual initiates a reverse mortgage, he or she is creating a huge liability because the loan must be repaid with interest. However, many individuals do not realize that establishing a reverse mortgage may jeopardize their ability to obtain financing at a later date.

On the surface, this may not seem like a concern for elderly homeowners given that they are unlikely to buy another home or make a sizable purchase, but it can have an adverse impact on applications for car and personal loans. It may also impact a homeowner's ability to acquire credit cards.

Reverse Mortgages May Impact Medicaid Benefits

Lending institutions are quick to say that obtaining a reverse mortgage will not affect one's Medicaid payments, but according to a site dedicated to lending sources, education and information, "if you receive Medicaid, any reverse mortgage proceeds that you take delivery of must be utilized right away." More specifically, the site says that any retained funds "will count as an asset and may affect your Medicaid eligibility." In other words, this means that if you were to receive $10,000 in a lump sum, you would have to spend that money shortly after receiving it. If you fail to do this, any money left over may count as an asset for Medicated eligibility purposes.

RateEmpire also states that if the total liquid resources are more than $2,000 for an individual or $3,000 for a couple, this could make the person ineligible for Medicaid.

Individuals currently receiving or anticipate receiving Medicaid should consult an accountant and a financial advisor in order to make certain that they are aware of all of the potential ramifications of taking out a reverse mortgage. (To learn more about Medicaid and long-term care, see Medicaid Versus LTC Insurance, Failing Health Could Drain Your Retirement Savings and Long-Term Care: More Than Just a Nursing Home)

Potentially Unfavorable Terms

While the lending institution may neither go after your heirs for money, nor are they entitled to take more than the appraised value of your home, there are several items usually located in the fine print of these contracts that can be disturbing.

For example, some reverse mortgages have clauses that state that the loan must be repaid if the home is unoccupied for a certain period of time. This means that the homeowner could (hypothetically) be in the hospital receiving treatment for a medical condition, and be released to find that their home is in foreclosure.

Furthermore, because homeowners remain responsible for all taxes, insurance and upkeep on the home, failure to pay taxes or maintain adequate insurance could cause the loan to be called.

Keep in mind that the property is also subject to an appraisal. So, while you might have put a large amount of money into your home over the years, there is the chance that it's worth less than you paid. This means that the proceeds that you receive as part of the reverse mortgage process may be less than what you might have anticipated.

Bottom Line

Reverse mortgages are a great way for people to tap the equity in their homes, either in installments or in a lump sum. However, be aware of the potential downsides to entering into such an agreement. (To find out more, check out Is A Reverse Mortgage Right For You?)